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The Roth Case

Tax Planning

Your clients, Ira and Flora Roth, have come to you for some basis tax planning advice and guidance. Here are the facts you need to help them.

• Ira’s earned income: $65,000
• Flora’s earned income: $52,000
• They live in Kansas and own a municipal bond issued by the city of Wichita (not a private activity bond). The bond’s face value is $100,000 and it has a 3.5% coupon
• Ira paid $12,000 in a alimony for the year to former spouse
• During the year they had a the following transactions

o Sold XXP stock for $11,000; originally purchased many years ago for $5,000

o Purchased 100 shares of HHP stock for $3,000 in April of the year

o Sold KSU corporate bond originally purchased on February 6 of the year for $15,000 (basis); they received $11,000 for the bond on November 12,

o Redeemed $4,300 worth of EE savings bonds in July that they had held for 12 years; the bonds earned 6% interest and had doubled in value

o Sold 1,000 shares of UNR stock at $7 per share that they had purchased earlier in the year for $13 per share.

* Flora age 61 received annuity distributions of $22,000 from a nonqualified annuity. T the beginning for the year, the annuity had a value of $300,000 and an after tax basis of $100,000. Her remaining life expectancy is 13.64 years

• Ira age 57 terminated employment and took a distribution of $199,99 from his 401K plan with the intent of rolling the money over to a Fidelity IRA in 30 to 45 days. His remaining life expectancy is 14.80 years.
• Ira and Flora paid $3,000 in housing expenses for their grandchild Chuck as a way to help offset some of his college expenses. They paid the $3,000 directly to Chuck.
• During the year, they paid the following items:

o $12,600 in unreimbursed medical expenses.
o $7,000 in mortgage interest
o $3,500 in property taxes
o $3,000 in state income taxes
o $2,800 in state and local sales taxes
o $1,000 to the salvation Army
o $2,400 to their church
o $750 to Kansas State University
o $500 in legal fees
o $100 in safe deposit box fees

• They contributed $3,200 to a Section 529 plan to help pay for Chuck’s college expenses

CASE QUESTIONS

#1) How much in long term capital gains did the Roths have for the year

a) -$3,000
b) $0
c) $1,000
d) $6,000

#2) Which of the following statement is true?

a) The Roths had $1,000 in short term losses for the year
b) The Roths had $4,000 in short term losses for the year
c) The Roths had $10,000 in short term looses for the year
d) The ROths had $15,000 in short term losses for the year

#3) How much (rounded) of Flora’s annuity distribution in taxable this year?

a) 33%
b) 67%
c) 75%
d) 100%

#4) Which of the following statements is true?

a) Ira’s employer will withhold $20,000 in federal taxes from the 401K distribution
b) Ira will owe an immediate 10% penalty on the 401K distribution
c) Ira will need to contribute only $80,000 to IRA rollover to avoid penalties
d) Ira needed to roll over the money to the IRA within 30 days to avoid taxes and penalties

#5) Had the Roths decided to give the XXP stock to a charity, they should have

I. sold the stock first and then made the donation for a deduction
II. donated the stock first and then taken he deduction
III. donated cash to the charity then sold the stock

a) I only
b) II only
c) III only
d) I,II, or III because they result in the same tax outcome

#6) Assuming they had decided to donate the KSU bond to a charity, they should have

I. Sold the bond first and then made the donation for a deduction
II. Donated the bond first and then taken the deduction
III. Donated the bond first and then deducted the loss

a) I only
b) II only
c) III only
d) I, II, III because they result in the same tax outcome

#7) How much can the Roths deduct from their federal taxes for the ss 529 plan contribution?

a) $0
b) $1,000
c) $2,000
d) $1,600
e) $3,2000

#8) In addition to the information already known about the Roths, you learn that Flora owns a vacant lot in Topeka that she purchased as an investment. She would like to exchange the lot so that she does not incur a tax liability. Which of the following properties can she take in trade to receive like kind tax treatment?

a) A duplex in Wichita
b) Collector coins owned by a coin dealer
c) A mortgage on a rental house in Topeka
d) A or C only

#9) Instead of doing a straight exchange with someone, assume that Flora finds a person who is willing to provide her a combination of property and cash for her vacant lot. Flora will receive $5,000 cash and a vacant lot in town valued at $10,000 (basis of $8,000). If her original lot has a fair market value of $20,0000 and a basis of $5,000, how much will Flora realize on this transaction?

a) $0
b) $5,000
c) $8,000
d) $10,000
e) $15,000

10) using the information in the previous question, how much gain must Flora recognize on the exchange for income tax purposes?

a) $0
b) 5,000
c) $10,000
d) $15,000
e) $20,000

Does ERISA regulate mandated benefits such as Social Security benefits as well as voluntary benefits provided by employers?

Donovan v. Dillingham, 1982 U.S. Court of Appeals decision (precedent)
A “plan” under ERISA exists if a reasonable person can determine:
The intended benefits
A class of beneficiaries
The sources of those benefits
A procedure for determining benefits

Using the above Dillingham factors, would there be a plan in the following fact scenario? If so, would it be a welfare plan or a pension plan?

A supermarket created a voucher system whereby it provided grocery vouchers to retirees upon their retirement from the store and the retirees could use the vouchers in lieu of cash to purchase goods at the supermarket. The supermarket established the voucher program according to an “executive memorandum” but had no procedures for administering the voucher program nor a trust fund to fund the voucher program. The voucher program was simply funded out of the supermarket’s general revenues and deducted as a business expense on the super market’s tax return. Explain your answer.

1. Jean Splicing will receive $50,000 in 50 years or $2,000 today. If long-term rates are 7 percent, what choice would you recommend?
a. What is the current value of the future payments
b. What is the current value, if they are received at the beginning of each year?

2. “Red” Herring will receive $11,000 a year for the next 18 years as a result of his patent. At present 9 percent is an appropriate discount rate.
a. Should he be willing to sell out his future rights now for $100,000 ?
b. Would he be willing to sell his future rights now for $100,000, if the payments will be made at the beginning of each year?

3. Larry Doby invests $50,000 in a mint condition “1952 “Rocket” Richard Topps hockey card. He expects the car to increase in value 8 percent per year for the next five years. How much will his card be worth after five years?

4. You need 28,974 at the end of 10 years, and your only investment outlet is an 8 percent long-term certificate of deposit (compounded annually). With the certificate of deposit, you make an initial investment at the beginning of the first year.
a. What single payment could be made at the beginning of the first year to achieve this objective?
b. What amount could you pay at the end of each year annually for 10 years to achieve this same objective?

5. If you can invest money elsewhere at 8% compounded semi-annually, what should be the market value (present value) for a 20-year $1,000 bond that pays 7% annual interest (with payments received every six months), as well as returning your $1,000 at the end of 20 years? (Note: Due to rounding in tables, answers using tables may differ by a few hundred dollars from those found using a business calculator.)

6. March Hair Ltd. just paid a dividend of $1.80, which it expects to be $2.90 next year and $4 the next year. After that time, the dividend will likely decline 5 percent per year forever. With required rates of return at 14 percent, what should investors pay for March Hair?

- Explain how inflation or purchasing power impacts stated or nominal interest rates.

- create a personal scenario that exemplifies the time value of money that includes the opportunity cost involved.

- Discuss the pros and cons of annuities when compared with other financial instruments and whether they provide a better investment opportunity for some people. Provide specific examples to support your response.

- Suggest a real-life example of how an annuity can be used for retirement planning

1.) You are considering three insurance settlement offers. The first offer includes annual payments of $5,000, $10,000, $15,000, etc., where the payment for each year is $5,000 more than the payment for the previous year, over the next ten years. The first payment of $5,000 will be made exactly one year from today and the last payment, equal to $50,000 will be made ten years from today. The second offer is the payment of one lump sum amount today. The third offer is to receive an equal amount at the end of each year, over the next ten years. Assume there are no tax effects and your discount rate is 12% per year. What is the minimum amount that you will accept today if you are to select the lump sum offer? What is the minimum amount of each of the 10 equal annual payments that you should be willing to accept?

2.) Joan Collins wishes to choose the best of four immediate-retirement annuities available to her. In each case, in exchange for paying a single premium today, she will receive equal annual end-of-year cash benefits for a specified number of years. She considers the annuities to be equally risky and is not concerned about their differing lives. Her decision will be based solely on the rate of return she will earn on each annuity. The key terms of each of the four annuities are shown in the following table.

See attached

Calculate the rate of return on each of the four annuities Joan is considering. Given Joan’s stated decision criterion, which annuity would you recommend?

3.) Junior Sayou, a financial analyst for Chargers Investments, a mutual fund management company, must evaluate the risk and return of two stocks, X and Y. The firm is considering adding these stocks to its diversified stock portfolio. To assess the return and risk of each stock, Junior gathered data on the annual dividends and beginning- and end-of-year prices of each stock over the immediately preceding 10 years, 2002-2011. These data are summarized in the accompanying table. Junior’s investigation suggests that both stocks, on average, will tend to perform in the future just as they have during the past 10 years. He therefore believes that the expected annual return can be estimated by finding the average annual return for each stock over the past 10 years. Junior believes that each stock’s risk can be assessed in two ways: in isolation and as part of the firm’s diversified portfolio of stocks. The risk of the stocks in isolation can be found by using the standard deviation and coefficient of variation of returns over the past 10 years. The capital assets pricing model (CAPM) can be used to assess the stock’s risk as part of the firm’s portfolio of stocks. Applying some sophisticated quantitative techniques, Junior estimated betas for stocks X and Y of 1.60 and 1.10, respectively. In addition, he found that the risk-free rate is currently 7% and that the market return is 10%. Note: you may find it easier and time effective to solve the problems using Excel or any other spreadsheet software. If you do, please use the drop box to submit your spreadsheet file.

See attached

a) Calculate the annual rate of return for each stock in each of the 10 preceding years, and use those values to find the average annual return for each stock over the 10-year period.

b) Use the returns calculated in part (a) to find (i) the standard deviation and (ii) the coefficient of variation of the returns for each stock over the 10-year period 2002-2011.

c) Use your findings in parts (a) and (b) to evaluate and discuss the return and risk associated with each stock. Which stock appears to be preferable? Explain.

d) Use the CAPM to find the required return for each stock. Compare this value with the average annual returns calculated in part (a).

e) Compare and contrast your findings in parts (c) and (d). What recommendations would you give Junior with regard to investing in either of the two stocks? Explain to Junior why he is better off using beta rather than the standard deviation and coefficient of variation to assess the risk of each stock.

4.) Assume that you have been hired as a consultant by S- Corporation, a major producer of chemicals and plastics, including plastic grocery bags, Styrofoam cups, and fertilizers, to estimate the firm’s weighted average cost of capital. S-Corporation has 500 million shares of common stock outstanding, 75 million shares of preferred stock outstanding, and 25 million 11% semiannual coupon bonds outstanding, par value $1,000 each. The common stock currently sells for $40 per share and has a beta of 1.2, the preferred stock currently sells for $75 per share and pays an annual dividend of $7 per share, and the bonds have 15 years to maturity and sell for 93.5 percent of par. The market risk premium is 6%, the yield on Treasury bills is 4%, and S Corporation’s tax rate is 35%. What is the firm’s weighted average cost of capital?

The Design Team just decided to save $1,500 a month for the next 5 years as a safety net for recessionary periods. The money will be set aside in a separate savings account which pays 4.5 percent interest compounded monthly. The first deposit will be made today. What would today’s deposit amount have to be if the firm opted for one lump sum deposit today that would yield the same amount of savings as the monthly deposits after 5 years?